November election sends chill down Valley shareholders' necks

Open... and Shut Across Silicon Valley, internet biz stocks are taking a beating as the market reacts to serious challenges at Zynga and elsewhere. Unfortunately, it may well get worse.

Due to the expected rise in US long-term capital gains tax rates under President Obama, the pressure on all technology stocks may hit new highs from the November election through the end of the year as investors and employees look to lock in stock sales at the current 15 per cent long-term capital gains rate.

Even as Silicon Valley pumps unprecedented levels of donations to Obama's presidential reelection campaign, their candidate promises to return the long-term capital gains tax rate to 20 per cent from its current 15 per cent for individuals in the 25 per cent tax bracket. Also, he promises to tack on an additional 3.8 per cent surtax for taxpayers with adjusted gross incomes of $200,000 or more (if single) or $250,000 or more (if married), to help cover some of the costs of his healthcare plan.

Median household income in the San Jose area, at the southern tip of Silicon Valley, is $83,944, according to US census records. Interestingly, the numbers of households making less than $35,000 or over $100,000 are growing. The rich in the Valley are getting richer, and the poor? Well, they're getting poorer. It's a fair bet that many of those $100,000-plus households are the same ones contributing to Obama's campaign, even as they take a 8.8 per cent tax increase in 2013 if they hold onto their stocks.

But will they dump their shares, and will it matter?

At Facebook, they may not have a choice. And it has nothing to do with presidential politics, and everything to do with an early executive decision to avoid going public by issuing Restricted Stock Units (RSUs) instead of stock options. As Fortune explains, the structure of Facebook's stock grants makes it more likely that employees will sell before the year ends:

Most IPOs have lock-up periods that bar employees from selling shares for six months. But Facebook's RSUs [restricted stock units] may make the end of that lock-up period more dicey than others. That's because, unlike with options, Facebook employees will owe income taxes on their RSUs whether they decide to sell them or not. And unlike options, there is no incentive to exercise your options and then not sell the stock so that you avoid income taxes and pay lower capital gains taxes. Facebook estimates that on average its employees will be hit with a combined state and federal tax rate of 45% on their RSUs. The result is likely to be a wave of selling in mid-November.

How much will this impact Facebook? Consider that a six-month lock-up on 277 million employee shares is about to expire in mid-November, adding to the total available pool of 421 million shares. As if this weren't bad enough, Facebook's largest venture investors hold another 400 million shares, and are likely to sell at the expiration of the lock-up. In other words, the number of outstanding Facebook shares could more than triple to 1.4 billion.

This isn't likely to help Facebook's already sagging share price.

Nor is the looming increase in long-term capital gains tax rates. As Adam Shell of USA Today writes: "Reducing the after-tax return on stocks could cause a headwind for Wall Street, because it could make the market less attractive and put a dent in the rally that has pushed stocks to their highest levels in almost five years."

The higher the taxes, the less appetizing an investment. In fact, he goes on to quote research from Strategas, a stock research firm, that indicates that in the absence of comprehensive tax reforms, past increases in long-term capital gains tax rates have resulted in broad sell-offs in the stock market.

Wall Street has pruned $9bn from the pocketbooks of rank-and-file employees at Facebook, Zynga, Groupon, and Pandora since their IPOs. With price hikes looming - going from 15 to 23.8 per cent for investors in the 25 per cent tax bracket; or from zero to 10 per cent for investors in the 10 to 15 per cent tax brackets - who wins in November's US presidential election, coupled with the need for Facebook investors to sell, anyway, may prompt a broad sell-off of tech stocks.

Not exactly the sort of news that makes for a happy Christmas season.

There are, of course, reasons beyond one's pocket book governing the choices in presidential elections. But if history is any guide, tech employees may be wise to sell their stakes in 2012 to avoid higher taxes in 2013. And many will. ®

Matt Asay is senior vice president of business development at Nodeable, offering systems management for managing and analysing cloud-based data. He was formerly SVP of biz dev at HTML5 start-up Strobe and chief operating officer of Ubuntu commercial operation Canonical. With more than a decade spent in open source, Asay served as Alfresco's general manager for the Americas and vice president of business development, and he helped put Novell on its open source track. Asay is an emeritus board member of the Open Source Initiative (OSI). His column, Open...and Shut, appears three times a week on The Register.